Dollars and Jens
Tuesday, October 04, 2005
interest rate policy
"The markets, if left to their own devices, would produce higher interest rates to ration money and balance the demand and supply of capital," [Dallas Federal Reserve Bank President Richard Fisher] said. "If the Federal Reserve were to resist the upward pressure on interest rates, it would in effect monetize the burgeoning fiscal deficits."
This is basically how I think about what Fed policy should be; I think it's a fairly Austrian way of thinking about it. Speaking colloquially, I sometimes say something is "inflationary" if I mean it would tend to raise interest rates — so that it would be inflationary for the Fed to hold interest rates where the neutral rate would otherwise be — if I don't feel like trying to change someone's whole monetaristic paradigm. This is the primary sense, incidentally, in which I understand both economic growth and large government deficits to be "inflationary" — they increase the product of capital and/or decrease savings, so as to raise the natural rate of interest.

Incidentally, how should the fed respond to high oil prices, which are largely exogenous to the U.S. economy? As a reduction in supply, it seems to me they would reduce returns on marginal capital investment, so I would tend to respond as though I were, in a classical sense, more concerned with the drag on the economy than with the inflationary effects. (I'm not certain that it will reduce returns on capital, and welcome with alacrity any thoughts on this.) On the other hand, Katrina, by destroying a lot more capital infrastructure than anything else (from an economic standpoint) (and creating, thereby, a lot of high marginal-value opportunities for new capital investment — and don't let sunk costs throw you here) should cause interest rates to rise. Not merely was it not a good enough reason for the Fed not to raise rates, it was a reason for them to do so. (Cataclysms, especially surprises, can cause a large increase in propensity to save, as people try to protect themselves for a rainy day; I think 9/11 did for a while, and lower interest rates — "liquidity", if you like — are then appropriate. Anecdotally, I don't see much of that from Katrina.)

In the cases where I'm arguing for higher interest rates, I'm not necessarily sure that the alternative is inflation; in fact, in the case of higher oil prices, I may well be accepting inflation, and my first impression is not that Katrina is literally inflationary. What these policies do, though, is reduce and mitigate the disruptions to the economy caused by these shocks — in Katrina's case, for example, by keeping too many resources from suddenly being driven to capital formation all at once, while inducing increased savings to go to the increase that does take place. (From that standpoint, maybe Katrina would be inflationary with fixed interest rates. I'm kind of thinking out loud here.) In the long-term, I suppose I expect these kinds of policies to lead to dollar-stability, but I'm thinking more about general economic stability.

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